Neil O'Brien is Director of Policy Exchange, an independent think tank working for better public services, a stronger society and a more dynamic economy. He writes in a personal capacity.

On public spending, there’s no plan B. This spending squeeze will last for decades

There is a big barney going on today in politics about whether the government is going to spend £5 billion on infrastructure, and whether this means the government is starting to wriggle out of its debt reduction plan.

I find it hard to get excited about this. Firstly, I don’t think they are going to shift. Secondly, although £5 billion is a lot of money, it’s a drop in the ocean of our economic woes. To put it into context, the government spends about £700 bn every year, our national income is about £1,500bn a year, and our national debt is rapidly spiralling towards about £1,400 billion. (That’s excluding the Government’s unfunded pension liabilities.)

In terms of its ability to make a significant difference to growth or debt reduction over the next ten years, whether government spends or saves £5bn is neither here nor there.

I find the discussion about the £5bn a bit depressing, because it is so symptomatic of the myopic, Mr Magoo style discussion we are having about the debt crisis. Let me explain.

When the coalition was first formed, there was a lot of talk about the “new politics.” What journalists meant by this was the novelty of coalition government.

Actually May 2010 did mark the start of a new era, but in a very different way. Although prediction in politics is normally hard, I can say with confidence that we have entered a new era, which will last for the next twenty years or so.

It’s a new era in which western governments will be paying down their vast debts, and won’t have lots of money to throw around. Many people assume that “dealing with the deficit” will last a couple of years, but then we will be able to return to politics as normal. Wrong.

At present the polls show only one in seven people even understand the difference between the debt and deficit – never mind the scale of the problem. When they hear politicians talking about "eliminating the current structural deficit" many people assume that the national debt will be paid off. Sadly not.

The chart below shows what the government thought the national debt would be in each of the last four budgets. Compared to the pre-recession budget of 2008, the numbers are much much worse. Compared to Alistair Darling’s last budget (in purple), the Coalition’s 2011 Budget (in pink) suggested that debt will stabilise and start to fall a bit earlier. But we will still have a mountain of debt to pay off.

The next phase of the debt debate

A new phase of the deficit reduction debate is going to start after the Autumn Statement, widely expected in November. The head of the Office for Budget Responsibility, Robert Chote, has already hinted that estimates of out deficit and debts will be revised up for various reasons. The FT has done some economic modelling and come to a similar conclusion.

So the trajectory of the debt might be somewhere between what Alistair Darling was planning and what the coalition had hoped to be able to do in the last budget.
At first glance, you might think this would be bad for the government. I can predict what Ed Balls will say now: the wicked, wicked government has cut too far and too fast, stalled the economy and ended up with higher debts. Boo, shame, etc.

Politically there is a problem though. If debt turns out higher than hoped, and what Ed Balls is offering in response is even more debt, are the public really going to buy that? I think not. In a great discussion we had on the future of the Labour party a week or two ago, a number of Blairites made the point that Labour has to get a credible economic story together, or it is going nowhere. I think Ed Miliband has until November to do that. The clock is ticking.

In the paragraphs above I talked about Alistair Darling’s plans for debt and spending, rather than “Labour’s” – because the party wasn’t united around them. In fact Darling was roasted by the “forces of hell” for refusing to borrow even more.

The truth that dare not speak its name in politics is that the difference between Allistair Darling’s spending plans and George Osborne’s is not that big in the grand scheme of things. Darling would have cut by £7 for every £8 the coalition is cutting. Without some truly, madly, deeply heroic assumptions about multipliers, there’s no way that such a small difference could have meant the difference between depression and recovery.

Of course, Darling is gone, and Ed Balls hasn’t said what his spending plans would be. But Labour have opposed pretty much every measure to save money. So we might conclude that spending would be much higher if he were chancellor.

Gordon Brown used to promise that the national debt would never rise above forty percent of GDP. George Osborne’s plan will see the debt peak at somewhere around 90% of GDP. Under Balls, we would be heading for what? 100% GDP? Not so long ago, we in Britain used to think that was banana republic territory. According to the Bank for International Settlements (BIS), 85% is the tipping point at which markets can suddenly spook, sending interest rates soaring and the economy plunging. As they say:

“beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems.”

So how much deeper into the danger zone do we really want to go?

Looking to the longer term

So far the debate about the debt has been dominated by an obsession with quarterly growth numbers and relatively small differences in public spending plans. We need to raise our sights a bit in three ways.

Firstly, it’s not at all clear that borrowing more would stimulate the economy. Research over the last twenty years suggests that the stimulatory Keynesian effects of extra borrowing are cancelled out by non-keynesian effects, even where deficits are much smaller than the ones we now have.

Secondly, journalists need to open their minds to the thought that the economy might not do that well over the coming decade, but that might have nothing to do with public spending.

Rogoff and Reinhart’s famous paper on the aftermath of financial crises shows why this might be different to a “normal” recession. The downturns that follow the bursting of great debt/financial bubbles can be very hard to get out of.

And a great paper from McKinsey shows just how laden down with debts the UK had become, even compared to our indebted peers. When it comes to indebtedness, we are number one with a bullet. (The UK is the green line streaking upwards.) Even stripping out the City, we are in a worse place than any other developed country than Japan (who just had two decades of stagnation).

Lots of economists think this long “de-leveraging” – the paying down of our debts – will mean pretty poor growth for a long time. So even if it were possible, “borrowing” growth from next year with a stimulus might be a bit pointless – if next year is going to be tough too.

Finally, we need to start looking to the long term. To get our debts down again over the next 20 years, Government will need to run a permanent surplus. According to an IMF report yesterday, we need to run a surplus of about 3.5% GDP for over a decade. But our best-ever performance so far is just 0.4%.

In other ways too, the long-term challenge facing Britain might be worse than it looks. As Chancellor in 2002 Gordon Brown decided that the trend rate of growth of the British economy had risen from 2.5% to 2.75% a year. This made his borrowing projections look much better. If the coalition took the trend rate down, the debt forecasts might look worse – but they might be more realistic.

In the future governments simply won’t have cash to splash, for years to come. This raises profound questions for both parties. How can the coalition grow the economy, when they don’t have lots of room for tax cuts? What’s the point of a Labour government, when it won’t be able to spend more? That’s the real “new politics”, and we’re all going to have to get used to it.